Supreme Court Determines Scienter for Defalcation

Posted by NCBRC - May 14, 2013

Debts for “defalcation” have been excepted from discharge for almost one hundred and fifty years, yet only now has the Supreme Court resolved the question of what mental state is required for an actor to commit defalcation within the meaning of section 523(a)(4). Bullock v. BankChampaign, 569 U. S. ____ (2013), No. 11-1518 (May 13, 2013).

The debtor was the trustee for a trust his father set up for the benefit of the debtor and his four brothers. While acting as trustee and at his father’s request, the debtor on several occasions borrowed money from the trust for his own benefit and for the benefit of his mother. On each occasion the debtor repaid the trust with the appropriate interest. His brothers learned of the transactions and filed suit for breach of fiduciary duty. The court entered judgment against the debtor for self-dealing, albeit without malicious intent, and ordered that he pay into the trust the benefits received from his actions. A constructive trust was established to receive the judgment, with BankChampaign serving as trustee. When the debtor was unable to liquidate assets to pay the judgment, he filed for bankruptcy seeking to discharge the debts owed to the trust by reason of the court judgment.

The bankruptcy court granted the bank summary judgment finding that the debts were non-dischargeable under section 523(a)(4) “as a debt for defalcation while acting in a fiduciary capacity.” The district court affirmed. Applying a standard of “objective recklessness” to the debtor’s actions, the court of appeals also affirmed.

The Supreme Court noted a longstanding disagreement among the circuits as to the scienter element of defalcation and granted certiorari. Dictionary definitions of the term dating back to 1852, and bankruptcy treatises as far back as 1842, failed to supply the necessary guidance, so the Court applied the doctrine of noscitur a sociis (“It is known from its associates”) to the historical cohorts of “defalcation:” embezzlement, fraud, and larceny. The Court noted that both embezzlement and fraud require an intentional wrong. In Neal v. Clark, 95 U. S. 704, 709 (1878), the Court found that for a debt to be nondischargeable due to “fraud” there must have been an element of “moral turpitude” or “intentional wrong.” Applying this reasoning to the case before it, the Court concluded that,

“where the conduct at issue does not involve bad faith, moral turpitude, or other immoral conduct, the term requires an intentional wrong. We include as intentional not only conduct that the fiduciary knows is improper but also reckless conduct of the kind that the criminal law often treats as the equivalent. Thus, we include reck­less conduct of the kind set forth in the Model Penal Code. Where actual knowledge of wrongdoing is lacking, we consider conduct as equivalent if the fiduciary ‘consciously disregards’ (or is willfully blind to) a substantial and unjustifiable risk that his conduct will turn out to violate a fiduciary duty. . . . That risk must be of such a nature and degree that, considering the nature and purpose of the actor’s conduct and the circumstances known to him, its disregard involves a gross deviation from the standard of conduct that a law-abiding person would observe in the actor’s situation.”

Nondischargeability provisions were designed to protect the comparatively more honest creditor in a situation in which the debtor has acted wrongfully. Therefore, limiting nondischargeability to those debts that involve a high degree of culpability on the part of the debtor conforms to this underlying rationale. The Court remanded to the court of appeals to reconsider the case under the higher standard set forth in this opinion.

Bullock opinion


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